Chapter 7-1: Public Finance and Fiscal Policy

Question 1

Government Revenue

Answer 1

Main contribution is taxation

Direct and indirect taxes

Question 2

Direct Taxes

Answer 2

E.g. Personal Income tax, Corporate tax, Property tax
Burden of tax cannot be transferred to another party
Person/ organisation pays the tax directly to gov
Change in direct tax affects C or I, impacting AD

Question 3

Indirect Taxes

Answer 3

E.g. GST, Value-added tax
Burden of tax can be transferred to another party
Change in indirect tax affects COP, impacting AS

Question 4

Structure of Taxation - Progressive Tax

Answer 4

E.g. Personal Income tax, corporate tax, property tax
Take up increasing proportion of income as income increases
Often used to achieve more equitable outcomes
Mitigate income and wealth inequality that naturally arises from the workings of the free market

Question 5

Structure of Taxation - Regressive Tax

Answer 5

E.g GST, ‘sin’ taxes
Take up decreasing proportion of income as income increases
Governments impose these due to the need to deter production or consumption / ability to generate and stable tax revenue

Question 6

Micro Impacts of Taxation

Answer 6

Impact on Resource Allocation (Efficiency)
- Indirect tax alters price and resource allocation
Impact on Income & Wealth Distribution (Equity)
- Direct progressive tax
Work Effort (Income, Substitution)

Question 7

Impact on Resource Allocation (Efficiency)

Answer 7

Indirect tax alters P and RA
Resources diverted from more heavily taxed to less heavily taxed sectors
Shift consumer choice and output in favour of untaxed goods
Can be used to alter production methods & address MF from negative production externalities (taxing pollution/polluting production methods)

Question 8

Impact on Income and Wealth Distribution (Equity)

Answer 8

Direct taxes tend to be progressive, so greater reliance on direct taxes leads to more equitable outcomes
However, increasing global competition for talent and investments - many countries decrease direct tax and increase indirect tax to make up for loss in revenue

Question 9

Work effort

Answer 9

Income effect
- Increasing personal income tax - Disposable income decreases, cannot afford to consume same G&S as before
- Work more to maintain existing levels of consumption
Substitution effect
- Increasing personal income tax - Hour’s work earns less disposable income than before - more willing to forgo that income in exchange for more leisure time

Income > Sub - People who want to maintain current SOL / have LT commitments (e.g families, debt)
- Work more to maintain disposable Y

Sub > Y - Few commitments (singles, dual-income earners etc)
- If tax structure is steeply progressive, high Y people are discouraged from working - but may still work for promotion

Question 10

Macro Impacts of Taxation

Answer 10

Impact on Macroeconomic Stability
- Gov influences economic activity
Impact on C
- Changing disposable Y affects C spending
Impacts on Savings & Investment
- Household's ability to save

Question 11

Impact on Macroeconomic Stability

Answer 11

Taxation can be used as a tool to influence the level of economic activity
Eg recession cut taxes to boost AD

Question 12

Impact on C

Answer 12

Increase in personal income taxes - decreased disposable income - discourages C spending

Extent to which C falls depends on MPC (Larger MPC - Greater decrease in C)

Poor tend to have larger MPCs
- Increasing tax rate likely to decrease C more for lower-income / less wealthy developing countries

Question 13

Impact on Savings and I

Answer 13

Increase in personal income taxes - decreased disposable income - decreases household’s ability to save
Less savings - less funds for firms to borrow for I

Increasing corporate taxes decreases post-tax profits, lowering incentive for firms to invest

Question 14

Types of Gov Expenditure

Answer 14

Gov Consumption / Recurring Expenditure - Day to day spending incurred (recurrent) e.g. wages of civil servants

Gov Investment / Capital Expenditure - Public spending on infrastructural development

Question 15

Micro Impacts of Gov Ex (2)

Answer 15

Impact on Resource Allocation (Efficiency)
- Varying type and extent of G affects pattern of production e.g. grants and subsidies to promote certain industries

Impact on Y & Wealth Distribution (Equity)
- G on health, housing, educational, social welfare & pensions - benefits poor
- Progressive tax system (revenue from taxing rich funds benefits)
Decrease extent of inequality in society

Question 16

Macro Impacts of Gov Ex (2)

Answer 16

Impact on Macro Stability
- Government uses G as a tool to influence level of economic stability (AD)

Impact on LR Growth
- Expenditure on infrastructure (e.g. transport, communications system) will improve prod cap / AS - boost output and employment in LR

Question 17

Fiscal Policy

Answer 17

Policies which aim to influence overall economic activity by altering level of AD of an economy through changes in G

Question 18

Discretionary fiscal policy

Answer 18

Demand management tool

Gov Budget - Estimate of gov revenue and expenditure for coming year
Balanced budget - T (revenue) = G
Deficit TG - Contractionary
Extra funds used to pay off existing gov debt / purchase assets to be a part of country’s fiscal reserves

Expansionary FP - Increase AD by budgeting for deficit
Contractionary FP - Decrease AD by budgeting for surplus

Question 19

Expansionary Fiscal Policy - Illustration

Answer 19

Output gap (Yf - Y1) suggests economy is facing demand-def. ExFP used to resuscitate economy

ExFP involves running budget deficit as G spending is raised while direct taxes are reduced
Higher spending by gov orgs e.g. on healthcare will directly raise G. Reducing personal Y tax or giving more transfer payments raises disposable income of households. Reducing corporate tax increases post-tax profits of firms, stimulating C and I

As G,C and I components of AD rise, output and income will also rise. Households spend part of additional income causing C to rise further. Some of income is STM, each additional round of consumption becomes increasingly smaller. Cycle stop when Y-induced C becomes negligible. Eventually through k process,…

Transfer payments - grants, unemployment benefits etc will not lead to G increase as no increase in production of G&S
Only increase in C when households that receive start spending

Question 20

Limitations of ExFP

Answer 20

Size of multiplier (MPC, MPW) - give reasons
Size of G relative to total demand - Small proportion of G, need to increase G more than proportionately to offset fall in AD

Size of domestic demand relative to external demand (X fall a lot, hard for FP to boost economy)
Time lags
- Increase in infrastructural spending - take time for various gov agencies to decide on what to spend on and how much to spend
- Time to construct

Tax Insensitivity

• Economic downturn, Consumer and business confidence weak
• More transfers / cut direct taxes - may still be reluctant to spend on C and I
• Impact of FP limited

Crowding-out effect
- Finance budget deficit by borrowing from financial markets
- Decreased amount of funds available for private households and firms to borrow
- C&I decrease, offset expansion in AD from initial increase in G
(Unlikely in severe economic downturn, firms and households too pessimistic to borrow, excess funds in financial market)

Question 21

Trade-offs of ExFP

Answer 21

Accumulation of National Debt

• Budget deficits financed from borrowing generating debt - paid back with interest in the future
• Opp cost of tax revenue used for paying back debt for other productive purposes
• Accumulate too much debt then financial markets concerned about ability to pay back, difficult for government to borrow more funds

Inflation & Overheating

• Excessive fiscal expansion, AD increase even when economy reaches Yf
• D-pull inflation
• Recession caused by supply shock - fiscal expansion boosts output and income but with higher inflation

Question 22

Why FP is still good

Answer 22

Definitely will have impact (increase in G component)

Indirect effect - boosting C&P confidence can spur I and C

Question 23

Contractionary FP

Answer 23

Demand-pull inflation - prevent overheating
Decrease G, Increase direct taxes
Raising personal Y and corporate taxes - decrease disposable income of households and post tax profits of firms, decrease C&I

Same old multiplier explanation
Diagram may show GPL decrease but aim is to lower inflation rAtes

Question 24

Limitations of ConFP

Answer 24

Small k
Small gov sector
M

Question 25

TOs of ConFP

Answer 25

Raising T extremely politically unpopular

• Households already suffering from high inflation
• Hard to implement, may lose political votes

Welfare spending decrease
- Hard for those affected

Increase DT
- Negative in LR as I curtailed, decrease incentive to work, difficult to attract foreign talent

Question 26

Summing up ConFP

Answer 26

• Severe limitations and trade-offs - rarely adopted on its own, often complements MP, which is still chosen over ConFP for fighting inflation
• Both ConMP and FP - risk of hard-landing if overly contractionary
• Long term - minimise inflation by ensuring sustained increase in prod cap - PG and AG increase in tandem

Question 27

Expenditure Reducing Policy to correct Trade Deficit

Answer 27

M>X

Not earning enough from X to pay for M
Finance M spending from 
1. Borrowing from overseas
2. Selling assets to foreigners
3. Drawing on foreign exchange reserves
Sacrificing future welfare for current C - Borrowed funds and interest must be repaid, Y generated by foreign-owned assets paid out in future to foreign entities, Depleted resources available for future use

Large and persistent trade deficits

• Reduce through expenditure-reducing policies (contractionary FP or MP)
• CGI decrease, AD Y and output decrease, Fall in M expenditure (ass. normal goods), Reduce trade deficit

Question 28

Correcting Trade Deficit - Limitation

Answer 28

Fall in NI may not lead to significant decrease in M if import demand is inelastic e.g. basic necessities

TO of decreased growth, increased unemployment

Question 29

Automatic Stabilisers

Answer 29

Fiscal Stabilisers
In-built systems which operate automatically to smooth out fluctuations in AD, decrease rate at which economy slows down or expands - counter-cyclical forces without direct gov intervention

Dampen D-pull inflation (personal income taxes, unemployment)
Slow down increase in DD unemployment
(opposite)

Lim: Reduce extent of overheating/contraction, not strong enough to reverse situation
TO: Hamper and slow down rather than facilitate recovery after recession (Fiscal Drag)

Question 30

Austerity Measures

Answer 30

Increase taxes and decrease G to bring budget deficit and rate of debt accumulation down to sustainable levels

Unintended consequences
- Reduction in material SOL (disposable income, AD, Real income decrease, unemployment increase)
- Reduction in non-material SOL
(Reduction in G - 3 categories, quality and accessibility, externalities, sense of security)
- Inability to achieve intended outcomes
(Economy contract, Y&C decrease, tax revenue decrease)
(Unemployment increase, more G on transfer payments, social spending)